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More start-ups choosing mergers over IPOs

By Scott Duke HarrisMercury News

Posted:
11/10/2007 04:15:24 PM PST

Tell us, Mike McCue. Why did you sell Tellme to Microsoft instead of opting for a dramatic Wall Street debut? Don't you listen to the venture capitalists? Don't you know that Silicon Valley dares to dream big?

But dreaming big, McCue says, is precisely why Mountain View-based Tellme became a Microsoft subsidiary in May for an undisclosed price some reports put at $800 million to $1 billion. Passing up an initial public offering, or IPO, to join Microsoft amid the "smartphone" revolution, he says, is a pivotal step toward fulfilling the grand vision that inspired Tellme in 1999: to make getting information from the Internet as easy as speaking into a phone.

"Life is too short to do something small," says McCue, who at 40 is part of a generation of entrepreneurs who started out as the Internet age was dawning. In the Microsoft deal, "we saw the intersection to create something absolutely huge - serving not just millions of people, but billions."

McCue is also part of the valley's current wave of venture-backed entrepreneurs who are much more likely to be acquired than go the Wall Street route with an IPO. Unlike the bustling 1990s, when the vast majority of start-ups with venture backing dreamed of going public, the dominant trend today is in mergers and acquisition, or M&A.

The reasons behind the shift vary from stiffer post-Enron corporate regulations that have added to the cost of going public to the maturation of industry sectors and convergence of technology.

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Add to that the deep pockets of tech giants like Cisco Systems, Hewlett-Packard, Oracle, Microsoft and Google looking to acquire small companies with innovative ideas.

The tougher accounting and governance standards imposed by the Sarbanes-Oxley reforms, venture capitalists say, are requiring young companies to grow larger before considering a play on Wall Street. The added annual cost of compliance for small companies is estimated at $2 million to $5 million a year, cutting deeply into a start-up's revenue. Still, others argue that the reforms have added more rigor to a business culture roiled by the stock options backdating scandal.

For venture capitalists, IPOs are often the preferred route for a young company. Dean Drako, founder and chief executive of the Web security firm Barracuda Networks, likens VCs to the gambler at the roulette table who judiciously scatters his chips across several numbers, knowing many will be lost but figuring one or two will pay off big. The entrepreneur, in contrast, always has a much larger stake on the table - in emotion, time, personal cash and sweat equity. With more to lose, the founder of a young company often prefers to place a safer bet.

In the 1990s, roughly half of the successful tech start-ups opted for an IPO. Now, just 10 percent of those companies go public. Mergers and acquisitions account for 90 percent of the "liquidity events" that reveal the market value of a start-up's equity.

'Fewer shots on goal' Over the past six years, according to the National Venture Capital Association, the number of tech IPOs nationwide has averaged 27 a year, compared with 157 a year in the 1990s, when the acronym became familiar to even casual investors.

"We're getting fewer shots on goal to create greatness," said Ted Schlein, a partner at Kleiner Perkins and chairman of the NVCA.

VCs argue that companies that get swallowed up have less chance to fulfill their potential. Imagine if Google had allowed itself to be gobbled up by bigger fish before its milestone IPO in 2004, they say, noting that now Google does the gobbling, such as its high-profile acquisition of YouTube as well as smaller firms. Generally speaking, that's bad for the larger economy, Schlein contends, because acquisitions rarely create jobs the way an IPO can.

But Tellme may be an exception to the notion that acquisitions don't create jobs. McCue says his company's deal with Microsoft will accelerate hiring, increasing Tellme's workforce from 300 to 400 within a year. Opting for an IPO, he said, would have slowed that progress.

While VCs like Schlein blame Sarbanes-Oxley for the downturn in IPOs, entrepreneurs like Drako and Zack Rinat, founder and CEO of the business software firm Model N, say the reforms have forced start-ups - and VCs in turn - to be more rigorous.

Start-ups, they say, have to focus more energy on growing a robust business with solid revenue - and not just angle for a quick payday via Wall Street. The days of the dot-com, easy-money frenzy are over, they say.

"A whole generation of entrepreneurs in Silicon Valley built to flip," Rinat says with disdain. "Only good companies can go public now."

Rinat believes the reforms may mean that weak companies with bad business models are more easily weeded out.

"Entrepreneurship is about overcoming obstacles. If you can overcome all of this, you'll have a lot less competition on the other side," he said. "From my point of view, I see it as an opportunity."

Drako, Rinat and McCue, however, have each pursued different strategies for their start-ups. That's because the decision about whether to go public or be acquired depends on everything from current market conditions to the industry sector.

Model N, Rinat's third company, was founded in 1999 with $41 million in venture funding. Its board includes Veritas founder Mark Leslie and Accel Partner's Jim Breyer, known for his investment in Wal-Mart.com and Facebook. Model N, based in Redwood City, successfully shifted its business model during the downturn from systems to financial software. It now develops "revenue management" enterprise software for life science and tech clients, including Johnson & Johnson, Pfizer, Amgen and Cypress Semiconductor.

Built to last "Philosophically, you don't build a company to get acquired," says Rinat. "I'm a fundamental believer that you build a company to last." That's why, he says, his previous software firms had multiple bidders: "If you do a great job, they come after you."

Rinat says he may be interested in taking Model N public - but only if the timing is right.

Drako also doesn't dismiss an IPO. But, having sold his previous companies, he knows the "downside and distraction" of going public. "You don't want to do it just for the sake of doing it," he said.

Barracuda - his fourth start-up, founded in early 2004 - introduced low-cost Web security appliances backed by software to help companies block spam, viruses, spyware and other intrusions. Confidence in their business plan and a distaste from previous dealings with VCs prompted Drako and partners Michael Perone and Zach Levow to finance the company themselves.

Barracuda, based in Campbell, was so quickly successful that it turned the tables on VCs: They eventually came to Barracuda offering investments. Drako said he turned down about a dozen offers before Sequoia Capital and Francisco Partners, in January 2006, "provided terms that were so good we couldn't turn them down." Barracuda banked $40 million for a "war chest," part of which was used to acquire NetContinuum, a provider of Web application firewalls.

For McCue, however, the choice was clear.

Tellme was launched in 1999 near the peak of the dot-com boom - one reason McCue was able to raise a breathtaking $250 million in just 15 months from an all-star roster of investors. McCue had earned their confidence as vice president of technology for browser pioneer Netscape, which he joined when it acquired his first start-up, Paper Software. Despite acrimony between Netscape and Microsoft, Tellme's early investors included former Netscape CEO Jim Barksdale and Microsoft executive Fred Silverberg, who later were joined by Kleiner Perkins' John Doerr and Benchmark Capital's Kevin Harvey.

Tellme's work is credited with inspiring the migration of large-scale phone services from proprietary applications to open standards applications. Today Tellme handles billions of calls annually for corporations and carriers nationwide, and operates the free 1-800-555-TELL consumer voice portal.

Just as a start-up seeking to go public needs a strategy, a young company evaluating a merger or acquisition also needs to have a larger vision.

That is why, he said, a visit to Redmond, Wa., to simply discuss a more modest partnership with Microsoft quickly evolved into something much bigger.

At a crossroads It was the Friday before Super Bowl Sunday. Microsoft Chief Executive Steve Ballmer demonstrated an impressive understanding of Tellme's technology and industry, McCue said.

Without divulging any private negotiations, McCue said, he explained to Ballmer that Tellme was at a crossroads, pondering two options: either an acquisition by a big company or a merger with another relatively small company, followed by an IPO.

McCue said he explained to Ballmer how, over his years of trying to guide Tellme's destiny, he had come to the conclusion that an alliance with Microsoft carried the greatest potential. Bill Gates, McCue likes to point out, long ago said people should be able to simply talk to their computers.

The outlines of an agreement were taking shape. Representatives of Tellme and Microsoft worked through Super Bowl weekend to hammer out a deal. By Monday, they had forged a deal that would close in May.

And that deal, McCue says, may someday enable you to have a meaningful conversation with your computer.